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FHA Loan Pros and Cons: What You Need to Know
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For many years, homebuyers needing lower down payments and more lenient qualifications have turned to Federal Housing Administration (FHA) loans. The U.S. government insures loans made to borrowers who may not qualify for conventional loans, but there are FHA pros and cons to consider before you apply.
- Pros and cons of FHA loans
- Conventional loans vs. FHA loans
- How to convert an FHA loan to a conventional loan
- Is an FHA loan right for you?
Pros and cons of FHA loans
FHA loans are popular for first-time homebuyers who have little cash saved up for a down payment and bumps in their credit history, but there are drawbacks to consider. Let’s take a look at the benefits and disadvantages of FHA loans in more detail.
- Low down payment with low credit scores. FHA loans require a 3.5% down payment with a credit score of 580 or more — much lower than the 620 score required by conventional lenders. Employers, close friends, family members or charitable organizations can contribute gift money towards your FHA down payment. In contrast, some conventional loan programs don’t allow gifts or restrict who can contribute gift funds for a down payment.
- Lower credit score with a higher down payment. The lowest credit score for an FHA mortgage is 500 to 579 with a 10% percent down payment. Applicants with credit problems, including bankruptcy or foreclosure in their recent financial history, may still qualify for an FHA loan when they would likely be turned down for a conventional loan.
- Higher debt-to-income ratio (DTI) is allowed. Your debt-to-income (DTI) ratio is calculated by dividing your total monthly debt payments by your gross monthly income. FHA loans allow for a DTI ratio up to 43%, although some lenders will accept a higher DTI under certain conditions. Meanwhile, a higher DTI may require a 740 score for minimum down payment conventional financing.
- Housing options. An FHA loan can be applied to several housing types: a single-family home, a multifamily home with up to four units, a condominium or a manufactured home that’s on a permanent foundation. Another perk: You can use an FHA loan to buy a multifamily (two-to-four unit home) with a 3.5% down payment and qualify with rent on the other units as long as you live in the home for a year.
- No income limits. Higher-income earners with credit problems can qualify for FHA financing with a minimum down payment. You can’t qualify for 3% down conventional loan programs, such as the Fannie Mae HomeReady® loan, if your household income is more than 80% of your area’s median income.
- Cheaper monthly mortgage insurance for low credit scores. If you can’t swing a 20% down payment, lenders usually charge mortgage insurance to cover the risk of default if you fail to repay the loan.You’ll pay the same FHA mortgage insurance premium regardless of your credit score. On the other hand, conventional private mortgage insurance (PMI) premiums are much higher if you have bad credit.
- Higher total mortgage insurance costs. Borrowers pay a monthly FHA mortgage insurance premium (MIP) and upfront mortgage insurance premium (UFMIP) of 1.75% on every FHA loan, regardless of down payment. A 20% down payment eliminates the need for PMI on a conventional purchase loan. You can also cancel PMI once you build 20% equity in your home.
- Restrictive housing standards. The government requires that all homes bought with FHA-backed loans are structurally sound and secure, and meet minimum health and safety standards. A particularly picky appraiser could make it difficult for a fixer-upper house to be approved for an FHA loan.
- Lower loan limits. Each year, the FHA sets FHA loan limits by county. This may impact how much home you can buy with an FHA loan, especially in high-cost areas. In general, FHA limits are 65% of an area’s conforming loan limits. For example, conforming loan limits in most parts of the country are $510,400, compared to $331,760 for FHA loan limits for 2020.
- Limited to a primary residence only. You can only use an FHA loan to buy a home you plan to live in as a primary residence. To finance a vacation or investment property, you’ll need a conventional loan.
- Lifetime mortgage insurance expense. If you opt for an FHA loan with a minimum down payment, you’re stuck with the MIP for the life of the loan. The only way to get rid of it is to refinance into a different loan type, such as a conventional mortgage.
Conventional loans vs. FHA loans
Choosing an FHA loan over a conventional loan may be easier if you compare the features of each loan side by side. Most conventional loans are backed by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are private companies chartered by the U.S. government to buy and sell mortgages on the secondary market.
Here’s how FHA and conventional loans stack up.
|Conventional Loans vs. FHA Loans|
|Loan feature||FHA loan||Conventional loan|
|Minimum down payment||3.5%||3%|
|Minimum credit score||580 with 3.5% down
500 with 10% down
|Loan limits||$331,760 to $765,600||$510,400 to $765,600|
|Maximum DTI ratio||43% (up to 50% is possible with enough cash reserves)||45% (up to 50% is possible for higher scores and enough cash reserves)|
|Occupancy||Primary residence only||Primary residence, second home or investment property|
|Mortgage insurance||0.45% to 1.05% of loan amount in annual MIP,
1.75% of loan amount in UFMIP
|Typically 0.15% to 1.95%, but as high as 2.5% of loan amount in annual PMI
How to convert an FHA loan to a conventional loan
The long-term cost of monthly mortgage insurance premiums can become burdensome on an FHA loan. You may want to explore refinancing options to lower your monthly payments.
To switch from an FHA loan to a conventional loan, you’ll need a 620 credit score to qualify. Also, once your equity reaches 20% of the home’s value on a conventional loan, you can request PMI cancellation in writing. However, you may need an appraisal to verify the home’s value. Lenders are legally required to terminate PMI on a conventional mortgage once you’ve reached 22% equity in your home.
Converting to a conventional loan will work much like a traditional refinance. You can shop three to five lenders to review loan estimates, and choose the best FHA interest rates and terms for you. You’ll pay closing costs again, but you may benefit financially from a lower monthly payment by switching from an FHA to a conventional mortgage.
Is an FHA loan right for you?
An FHA loan can be an excellent choice for a new homebuyer or someone with a spotty credit history. With its low down payment requirements and lenient credit standards, an FHA loan may be affordable if you don’t have a lot of upfront cash to put down.
However, homebuyers should compare FHA loan pros and cons, namely the long-term costs of monthly and upfront FHA mortgage insurance premiums with the shorter-term cost of PMI on a conventional mortgage, to decide which loan type makes more financial sense.